Cuts AHOY!

Whilst stock markets and earnings season have dominated the headlines, with the S&P 500 breaching 5,000 for the first time, there has been a significant repricing of when and by how much interest rates will be cut over the course of 2024. And whilst the rapid demise of New York Community Bancorp is being sold as an exception, it is rare for this to be the case. There may well need to be a rethink on impact to the broader financial system and not just in the US, as little fires are popping up closer to home.

Macro

Fewer cuts and further out has been the name of the game thus far this year. How this plays out with signs of contagion in commercial real estate markets may have a say in when and by how much central banks’ hands might be forced with not only the blunt tool of cheaper money but other policies designed to ease property pain. Deutsche Pfandbriefbank (graphed below) of Germany and Japan’s Aozora Bank have both seen their share prices take a hit. As is often the case, investors are already looking for the next victims.

Source: Bloomberg LLP

This has been unfolding before our eyes for four years now in China, where the most leveraged of property developers have been falling by the wayside. The government and the central bank have been forced to make concessions along with providing support to prop up waning demand which has pulled down growth – both real and projected. Chinese overseas property purchases are starting to hit international markets too. Firms are selling in the US, Europe, and Australia in just the last couple of weeks. The trouble though is that liquidity is poor as repricing continues. Overall, commercial property transactions have sunk to the lowest rate in a decade. Buyers are seeking steep discounts to book value. It’s also not just the professional investor getting jittery, more broadly, real estate funds have seen attrition to the tune of EUR 1 billion/month. At some point something’s gotta give. According to Man Group portfolio manager Jonathan Golan, “…there are portions of the market that we think are in very deep trouble”.

Risk

Now well into 2024, we have a better feel for risk assets. Divergence is the clear theme here with the winners being the US and Japan, both showing signs of strength and perceived outperformance with the Nikkei gaining 7% in seven weeks. In the States, it is not only the S&P that has seen some love, across the board we are “up”. In part due to corporate performance, and more broadly a belief that any landing will be soft, or in other words no damage done from higher rates. Europe and much of the rest of APAC though is in the red. See below for stocks dropping following Tuesday’s US inflation data.

Source: Bloomberg LLP

Credit

Contrary to what one might expect, borrowers far and wide have been taking advantage of abundant liquidity at what is supposedly peak rates. Whilst this may not make sense with the overall picture pointing to cheaper money soon, lessons have been learnt. New issuance records continue to be broken, the other side of the coin being investors who are hungry to lock in higher rates and profit from cuts as and when they come. Prudence is no bad thing. We have all learnt that large unexpected events can be debilitating if one is not adequately cushioned. Frankly with the scale of bets being parred back, a lot of that funding is not looking as expensive as it may have at the time. Thus far the bulk of issuance has come from governments and the SSA market. Once we get through bank and corporate earnings there will be greater variety on offer. Spreads remain incredibly tight. No real premium for taking on additional credit risk. Let’s see what output we get given the flurry of elections and the already flamboyant mix of additional inputs.

EUR

Property woes aside, the growth engine of Europe, Germany, has all but stopped. Industrial production figures last week not only saw a decline, but four times worse than expected at -1.6%. The OECD reported back in September that out of all developed countries, the nation was most exposed to the combination of higher interest rates and weaker global trade. This appears to have now come to fruition. Energy costs and dependency on importing also creating headwinds here. When might the saviour of cheaper money arrive though? Well…since last putting pen to paper the implied base rate for the end of the year has shifted up almost half a percent. Overall the picture is looking slightly better with employment and inflation both behaving. Below sets out implied rates at each central bank meeting to the end of the year.

Source: Bloomberg LLP

GBP

If you thought interest rate expectations had shifted in Europe, you ain’t seen nothin’ yet! Not only has the timing of a perceived cut been pushed out to September following US CPI (more on that later) but the degree of easing has moved sharply lower. In the last month alone the size of cuts has been, well…slashed. By more than half. A full 0.85% has been taken off the table. This may seem overly optimistic given we heard last week that following two consecutive weeks of negative growth the UK was/is in a technical recession. Governor Bailey speaking at Loughborough University on Monday reiterated that the economy is okay. This is just a blip. Employment data continues to beat expectation with jobs growth and, somewhat alarmingly for the central bank, wage inflation, which in the 3 months to December (annualised) rose 6.2% (ex-bonus). We’ll know more on growth at the end of the week with Friday’s GDP print.

USD

There are many phrases knocking around trading floors far and wide. Some are simply distasteful and not to be shared. Others though, have stuck with me and ring as true today as when I had hair and not a care in my early 20’s. “Don’t fight the Fed” exclaimed dealers who on that particular day happened to be correct, sometimes for all of just a few minutes, but enough  to “get out” and “bank” profit. Governor Powell & Co have been pretty clear for some time: rates can and will only come down once inflation is tamed. We have been reminded of two things. First, despite the repricing of where rates are likely to be over the course of the year (you guessed it, higher for longer…) there was still room to go; and secondly, always be prepared. CPI (year on year) has held at 3.9% whilst January saw a month on month price increase of 0.40%. Guess we’ll need to see wages go up from here and continue to ride this merry-go-round until something busts.

Source: Bloomberg LLP. Spot the time of the data release!

There is a rebellion at foot though. According to the latest survey from the National Association for Business Economics, over 20% of respondents figured rates were prohibitive. One might expect that, but when accounting for time it is the highest since 2011.

Source: The Economist

So what?

For now, everything appears to be ticking along quite nicely. However, history teaches us that rates peak for a reason…they need to be cut to give economies a much needed boost. The market is speculating not only when or by how much. It is also telling us we are getting closer to time at the bar. Will it be commercial real estate, stagflation (where outsized price growth continues but GDP flatlines), or does something else go pop? No matter what, best stick to the motto of the Scouts: “Be prepared”.